PSST vs. the Aggregate Production Function
Regular readers know that I am trying to nudge them toward a different paradigm in macroeconomics. I want to get away from thinking of economic activity as spending, and instead move toward thinking of it as patterns of sustainable specialization and trade. Even if there is only a small chance that this alternative paradigm is useful, I think it is a worthwhile exercise.
One reason for wanting to change the paradigm is that I believe that trying to describe economic activity using an aggregate production function is a mistake. When I use the derisive expression GDP factory, I am referring to the aggregate production function.
The advantage of the aggregate production function is that, when combined with a sticky nominal wage, it yields an aggregate supply curve. This allows macro to be presented using the familiar tools of supply and demand. My problem is that I think that the GDP factory is a bogus story that obscures rather than enlightens.
Instead, I think that the right tools to use for macro are the two-country, two-good models of international trade. The “two countries” could be two sectors within an economy. The agricultural sector and the urban sector. The housing sector and the non-housing sector. And, of course, there are many more than two sectors. But just talking about two sectors is a big improvement over the GDP factory.
At full employment, both countries are taking advantage of specialization and trading with one another. When something happens to adversely affect the pattern of trade, some workers shift from market activities to non-market activities, mostly in the form of involuntary unemployment. Gradually, new patterns of specialization and trade emerge, and full employment returns. That is what I have been calling the Recalculation Story.
Austrians want to focus on changes in the capital intensity (or “roundaboutness”) or production as the typical (only?) shock that can affect the pattern of trade. I will grant that in practice this can be important, but I do not wish to make it the central issue.
More comments below.1. The conventional “spending” paradigm (which includes both monetarist and Keynesian versions of AS-AD) says that output is “lost” during a recession. That is what is meant by a term like GDP gap, the shortfall of GDP from the level it would be at full employment. (Yet people sometimes speak of under-consumption. We under-consume, and yet there is a shortfall in production. Strange, no?)
I want to suggest that the output that is “lost” is output that people do not want. In 2008 and 2009, Americans do not want 2 million houses to be built. So I do not think that it is right to speak of a shortfall in output. Instead, we should say that the people who were building houses have not found a pattern of trade in which they can produce something that people want.
2. I think that technological change can drive the marginal product of many workers close to zero (When I mention ZMP, I always feel I owe Tyler Cowen a footnote.) I suspect that this happened in agriculture in the U.S. in the late 1920’s and early 1930’s, dumping a lot of manual laborers into unemployment. I suspect that it has happened in recent years because of the Internet. The Internet has created many new white-collar occupations, but by the same token even more white-collar workers have seen their marginal product fall to zero.
Eventually, the mix of workers changes, mostly due to older vintages dying off and newer vintages appearing. New trading patterns develop, we see a decline in the number of workers with low marginal product, full employment is restored, and productivity and earnings are much higher than before.
3. I wonder if the real public policy issue is not restoring full employment but coming up with a fair distribution of leisure. That is because with high levels of productivity, it is arithmetically possible to sustain a high ratio of dependents to workers. However, this is not easy to come to terms with politically. The dependents may suffer from low self-esteem. The workers may feel resentment.
I would expect that advances in productivity will increase leisure. One could argue that this is already happening. Actual retirement ages (as opposed to statutory ones) are falling, even as longevity is increasing. (I am speaking of the dominant trend, notwithstanding whatever brief disruption might have been caused by the financial crisis.) The age at which young people are expected to “settle” into adult life styles is rising. Even for people with “regular” employment, there are many jobs that include a large leisure component, including surfing the Internet and chatting up co-workers.
It could be that when the unemployment rate falls back closer to 5 percent, what we will have is a distribution of leisure that makes people happier. More young people will be experimenting with their lives (traveling, changing fields, trying to start businesses), more people will be retiring early, and only in between will most people by working at normal jobs.
Jan 13 2011 at 12:01pm
This is one of your better posts selling the PSST narrative. I will have to look into some international trade models. I know almost nothing but a few stylized facts about the field.
Jan 13 2011 at 12:24pm
Looking in the trade literature is a good place to start. Maybe my comparative statics are screwed up, but suppose we start from a world of zero transaction costs and two industries A and B that are have an equilibrium wage and number employed. Suppose labor saving technological change is introduced in A. Then,
1) The first order effect is the demand for labor in A shifts left causing equilibrium wages and number employed in A to drop.
2) The labor supply in B shifts rightward causing equilibrium employment to rise and wage to fall.
In between 1) and 2) you could come up with some creative step 1′ that explains involuntary unemployment (for example, high fixed costs of searching for a new job match on both employee and the employer side).
In practice though, when labor saving tech change is introduced in one industry do we see wages drop across industries? If not, what am I leaving out?
Jan 13 2011 at 1:01pm
That’s what Austrian econ does, only the two sectors are capital goods and consumer goods. Every intro micro textbook uses the Austrian two-model economy when they show a PPF with two goods labeled either future vs present goods, or investment vs consumption.
Actually, the pattern of trade causes the shock; the change in capital intensity is the response to the shock in Austrian econ.
Exactly! Capital goods production and consumer goods production must be in balance. The “lost” production is the excess production of capital goods, such as houses and cars caused by credit expansion.
Jan 13 2011 at 1:06pm
Recalculation? Yes, but isn’t recalculation going on all of the time? Sometimes more than other times and for a wide range of reasons: fades, technology changes, bad investment decisions (over-investing), etc.
We over-invested in housing; not just houses but the entire supply chain. One day we wake up and the labor and capital in this sector cannot generate as much income as before — and won’t for a long time.
It seems to me that the only way to get real income back is to invest in new things that people want (as appropriately noted, it is what people want — not what some people want for the rest).
I think the current recession is dragging because political system discouraged (prevented) new investment by A) borrowing and redirecting our limited savings away from investment and toward consumption type activites and B) by creating significant economic uncertainty.
It may be that the recalculation most needed is a shift of labor and capital away from government and back toward the private sector.
Jan 13 2011 at 1:12pm
“I want to get away from thinking of economic activity as spending, and instead move toward thinking of it as patterns of sustainable specialization and trade.” Does anybody really identify economic activity with *spending* (= buying)? How about *selling*? How about *producing* and *consuming*, *saving* and *investing*? (Arnold’s ‘sustainable specialization’ probably refers to specialization in *production*.) Another activity that is often recognized–but not as often as it should be–is *learning* (= acquiring information); Arnold probably means to include that: a lot of what he considers “economic activity” is probably *searching for* “sustainable patterns.”
But why the emphasis on *sustainability*? Of course, if I find a profitable niche for myself, I want it to endure a long time, so I can continue to profit from it. But I am still glad to seize an arbitrage opportunity today, even if I know it will disappear tomorrow. Any demand for sustainability would be mere laziness–a wish to avoid having to keep looking for opportunities in the future.
Jan 13 2011 at 1:52pm
Or reading economics blogs…
I agree with that sentiment wholeheartedly and you have put it as succinctly as I have ever heard it. However, if you try framing the debate this way with an assembly-line worker (or practically anyone else in a “settled” job), you may find yourself in a fist fight.
Jan 13 2011 at 2:03pm
If we addressed recessions with work sharing we would have a much more equitable arrangement with less unemployment and more leisure and still offer the opportunity to develop new specializations. It would not necessarily solve everything, more housing is not needed, but it would limit the need for large government action to remedy the problems created. There would not be any need for unemployment in every area of the economy as there is now.
Jan 13 2011 at 5:27pm
I think the non-monetary overinvestment theories of Spiethoff and Cassel may be of particular interest to you and indeed a synthesis between these views and those of the Austrians may be fruitful in providing a more general theory of macrofluctuations than the Austrians alone.
Jan 15 2011 at 12:58pm
If there is a general productivity increase that allows each sector to produce the same amount with 10% less labor, then a recalculation would be necessary to find new levels for wages, demand for leisure (part of the productivity increase might be taken in form of leisure), and the structure of demand for the various goods and services (shift toward goods and services that are complementary to leisure). Is what you are saying in your third point that the Recalculation Story is not only about sectoral shifts but is also relevant for shifts between production and leisure? For this latter kind of shift, you can tell part of the Recalculation Story in the GDP factory framework.
By the way, you are right that advances in productivity have increased leisure. But leisure has not increased as much as one might have expected. I have summarized reasons why one may not want to work less (see http://unintendedoutcome.blogspot.com/2010/12/why-do-we-work-so-much.html).
Jan 15 2011 at 1:40pm
The overinvestment in housing is the big non-financial mistake. Of 2002-2006. The failure of the economy to recalculate between 2006-2008 (Lehman fail) is one huge theory-practice problem.
People want a house for two reasons: a) to live in, b) for speculation. Once prices stopped going up, it was only (a). Houses to live in, w/o speculation/ saving on appreciation, are much much less valuable. But all the downstream appliances & furnishings that go with housing are also hit hard.
The failure to find the “next highly desired product” is based partly on fewer customers having cash to play around with on unknown consumables. That so many illegals lost their jobs is also not fully reflected in the statistics, especially on unemployment.
@Lord, I agree with job sharing!
Starting with gov’t workers: all gov’t workers making 3x the median wage should be shifted into half time work, and that part of their job which they are doing relatively worse in should be delegated. Then there would be a starting level job for each shrunk-shared gov’t job, without costing any more. If that’s not enough new workers, those at 2x of media should also go into job sharing — for the entry level workers!
Jan 28 2011 at 7:28pm
I had thought the emphasis on sustainability was because with a population approaching 7 billion and the idea that said population will likely double within about 80 years even with a slow decline in growth, we need to figure out how to get by making less stuff but still trying to improve living conditions for everyone. Am I missing some endless cornucopia of resources or? If this pursuit is laziness, you can sign me up. Otherwise, I’ll see you in the Thunderdome I reckon.
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